How the Fiduciary Rule Impacts 529 plans

On Wednesday, April 6 the U.S. DOL (Department of Labor) unveiled new rules that are, in aggregate, widely-referred to as "The Fiduciary Rule." In short, the new rules require financial intermediaries providing retirement guidance to act in the best interest of their client. The DOL is hopeful that the new legislation will reduce billions of dollars of fees paid by investors saving for retirement.

Previously, advisors were required to meet what is called the "Suitability Rule," which is defined by FINRA Rule 2111 as having a, "reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through reasonable diligence."i In layman's terms, it means that an investment has to be suitable, meeting investment objectives, risk characteristics, and time horizon. If the advisor were selling cars, it would mean they could sell you the most expensive car on the lot even though you really only needed something half the price.

The Fiduciary Rule is more strict. If a financial intermediary has two different investment options that are both suitable, but one has lower fees, they are obligated to offer the less-expensive option. In car terms it would mean that the salesperson must offer you the less-expensive option.

So what does this mean for the college savings marketplace? Total assets in the U.S. Retirement space were approximately $24 trillion as of the end of 2015, according to the Investment Company Institute. By comparison assets in 529 college savings plans were less that $250 billion during the same period. To have the greatest and furthest-reaching impact on advice standards it made sense for the Government to go after retirement savings. However, even though the rules only impact retirement assets today, it sets a precedent for advisors of all types.

It would not be surprising to see similar legislation or rules put in place regarding college savings products given their nature and the environment of distrust towards financial service providers following the 2008 financial crisis, not to mention the market-timing scandal of 2003. However, there are several factors working against the implementation of similar rules for college savings in general, but specifically 529 plans, because existing structures make a Fiduciary-type rule largely redundant:

The twice per year annual exchange limitation prevents advisors from "churning" within any 529 plan to create excessive fees. This may be one of the few real benefits to investors of the annual restriction!

Section 529 plans are state-sponsored municipal securities. While the plans themselves are primarily run by private investment providers such as Fidelity, each has State oversight. The State already has a fiduciary obligation to look out for its respective plan participants.

Section 529 plans are relatively low-cost. In fact, in some cases you can get access to lower-cost investments inside a 529 plan than at retail because the provider is offering access to institutional or preferred share classes in the underlying securities.

Several plans have already begun to implement class structures for advisor-sold plans that shift participants to the lowest-cost share class after a specified period. Tomorrow's Scholar 529 plan, for example, offers a C Share that automatically converts to a load-waived A Share after six years.ii

In-state tax benefits more often than not make an advisor's choice for them when recommending a plan to a client.

All that said, there are some plans out there that are somewhat needlessly expensive, but they are more the exception than the rule. There is also no widespread evidence that intermediaries are abusing the sale of 529 plans due to fee incentives. If anything, 529 plans are so inexpensive that advisors are more likely to not bother offering them than to push them in an effort to generate fees.

Still, long-term it would not be surprising to find some variation of the Fidicuary Rule applied more broadly. There is international precedence to this effect.iii What this could mean is that college savings vehicles would be brought under rules implemented that apply more broadly to those providing investment advice regardless of product. The result would be additional pressure on those plans with the highest fees to become more competitive, and for more stringent oversight from financial intermediaries of those advisors offering 529 plans to ensure their reps were meeting requirements.

In general, the Fiduciary Rule should be good news for investors. Lower fees and more diligent advisors acting on their behalf will likely yield net benefits down the road, though retirement advisors will not be required to implement the new fiduciary standards until April 2017 ("full" compliance will not be required until Jan 1, 2018). However, it is unlikely that similar measures will be taken in the college savings marketplace in the near future without some sort of unforeseeable event prompting said action.

On Wednesday, April 6 the U.S. DOL (Department of Labor) unveiled new rules that are, in aggregate, widely-referred to as "The Fiduciary Rule." In short, the new rules require financial intermediaries providing retirement guidance to act in the best interest of their client. The DOL is hopeful that the new legislation will reduce billions of dollars of fees paid by investors saving for retirement.

Previously, advisors were required to meet what is called the "Suitability Rule," which is defined by FINRA Rule 2111 as having a, "reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through reasonable diligence."i In layman's terms, it means that an investment has to be suitable, meeting investment objectives, risk characteristics, and time horizon. If the advisor were selling cars, it would mean they could sell you the most expensive car on the lot even though you really only needed something half the price.

The Fiduciary Rule is more strict. If a financial intermediary has two different investment options that are both suitable, but one has lower fees, they are obligated to offer the less-expensive option. In car terms it would mean that the salesperson must offer you the less-expensive option.

So what does this mean for the college savings marketplace? Total assets in the U.S. Retirement space were approximately $24 trillion as of the end of 2015, according to the Investment Company Institute. By comparison assets in 529 college savings plans were less that $250 billion during the same period. To have the greatest and furthest-reaching impact on advice standards it made sense for the Government to go after retirement savings. However, even though the rules only impact retirement assets today, it sets a precedent for advisors of all types.

It would not be surprising to see similar legislation or rules put in place regarding college savings products given their nature and the environment of distrust towards financial service providers following the 2008 financial crisis, not to mention the market-timing scandal of 2003. However, there are several factors working against the implementation of similar rules for college savings in general, but specifically 529 plans, because existing structures make a Fiduciary-type rule largely redundant:

The twice per year annual exchange limitation prevents advisors from "churning" within any 529 plan to create excessive fees. This may be one of the few real benefits to investors of the annual restriction!

Section 529 plans are state-sponsored municipal securities. While the plans themselves are primarily run by private investment providers such as Fidelity, each has State oversight. The State already has a fiduciary obligation to look out for its respective plan participants.

Section 529 plans are relatively low-cost. In fact, in some cases you can get access to lower-cost investments inside a 529 plan than at retail because the provider is offering access to institutional or preferred share classes in the underlying securities.

Several plans have already begun to implement class structures for advisor-sold plans that shift participants to the lowest-cost share class after a specified period. Tomorrow's Scholar 529 plan, for example, offers a C Share that automatically converts to a load-waived A Share after six years.ii

In-state tax benefits more often than not make an advisor's choice for them when recommending a plan to a client.

All that said, there are some plans out there that are somewhat needlessly expensive, but they are more the exception than the rule. There is also no widespread evidence that intermediaries are abusing the sale of 529 plans due to fee incentives. If anything, 529 plans are so inexpensive that advisors are more likely to not bother offering them than to push them in an effort to generate fees.

Still, long-term it would not be surprising to find some variation of the Fidicuary Rule applied more broadly. There is international precedence to this effect.iii What this could mean is that college savings vehicles would be brought under rules implemented that apply more broadly to those providing investment advice regardless of product. The result would be additional pressure on those plans with the highest fees to become more competitive, and for more stringent oversight from financial intermediaries of those advisors offering 529 plans to ensure their reps were meeting requirements.

In general, the Fiduciary Rule should be good news for investors. Lower fees and more diligent advisors acting on their behalf will likely yield net benefits down the road, though retirement advisors will not be required to implement the new fiduciary standards until April 2017 ("full" compliance will not be required until Jan 1, 2018). However, it is unlikely that similar measures will be taken in the college savings marketplace in the near future without some sort of unforeseeable event prompting said action.

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